Wednesday, March 30, 2011

The Multiplier Myth Revisited




The citizens of the united States live better today than at any time in history. The country is cleaner, all sectors of the population are richer, and live longer. Things seem to have improved in direct proportion to our economic growth, and I would argue it happened because of that economic growth. The shortest life spans and the dirtiest environments in the world are in the least industrialized and poorest countries. Therefore, it is incumbent on us as a nation to decide what course we should take to best continue and accelerate that growth. Simply put, we must decide what works.


There has been an ongoing debate between two almost polar opposite schools of thought on a basic economic theory, one being Keynesian economics and the other supply-side theory. Democrats subscribe to the Keynesian theory (JFK being an exception), and their policy decisions have been guided by it. Republican policies are based on supply-side theory. The choice between the two is vital and will determine whether the country continues on the road to prosperity, or if it becomes another failed grab at a Utopian dream.

In 1936 John Maynard Keynes published The General Theory of Employment, Interest and Money, which proposes that if the government stokes the demand side of the demand supply chain through increased spending, there is a stimulative effect on the economy. The idea is that the direct recipients of the increased spending will themselves spend more, as will the recipients of their spending etc. This sort of government induced momentum creates a "multiplier effect" (the term he used to describe the process), increasing economic activity, creating jobs and creating wealth. The whole idea rests on notion that if by any means consumption is increased, the economy will grow in a sustained way.

Keynes thought government should intervene during a recession with large direct expenditures, priming the economic pump regardless of where the money is spent. This idea was stated in the extreme when he said that if the government paid to have dirt moved from one hole to another, the resulting "multiplier effect" would build economic activity to a point where the money expended would be unimportant when measured against the increase in economic activity. Think about what he is saying. The mere expenditure of money will in itself create wealth.

This theory is embraced by all liberal economists. It is the basis on which Hoover and Roosevelt made most economic decisions trying to get us out of the depression, the theory which Japan has been employing for more than 30 years, and the theory on which the current administration is basing their entire economic policy. They have been trying to spin straw into gold. It won't happen. 

Instead of talking about supply and demand, let's talk about what really is going on; wealth creation and wealth destruction, aka consumption. Wealth creation is the process whereby work, investment, imagination and perhaps a little luck come together to create something of utility that did not exist before. It is this wealth creation and the cycle that follow which few really understand. Unlike the physical universe where matter and energy can neither be created nor destroyed, wealth is continuously created and destroyed (consumed). Work in the form of labor is one ingredient, as is ingenuity and creativity. The last component is investment, which putting capital at risk (often pooled capital) in the hopes of creating wealth.

Consumption is no more than the destruction of wealth. Of course that is the purpose of wealth creation, to consume. At a minimum it is necessary to survive. This idea is not pejorative. It is simply a fact. We eat food and it is gone. We drive a car, and after a few years it no longer works. Clothing and housing have finite lifespans and must continuously be replaced.

Poker is a zero sum game. Every dollar won is lost by someone else. Total losses and gains are always equal. The economy is not a zero sum game, but rather an expanding universe. The most difficult concept to grasp about wealth creation (even though it occurs every day right in front of our noses) is that it really is creation. Something is truly created from nothing. This phenomenon explains how it is possible that many economic transactions profit all the participants, owners, employees, customers and even people on their periphery. Through work, or investment, or both, wealth is continuously created in every way imaginable, from the creation of new products, to new applications of existing products, to simply improving those existing products. Unlike poker, wealth creation allows for infinitely more winners than losers.

The relationship between work and wealth creation is simple. A tree has a certain value. If work is invested and it is harvested and delivered to a mill, because it has more utility than it did as a tree, its value goes up. When the sawmill strips the bark and cuts it into manageable pieces, it too increases the value. And when a carpenter forms those pieces into a chair, once again he has created/ added more value. The retailer who brings the product to his area and gives customers choices of what to buy, has added value (what good would a finished chair be sitting in a mill without buyers being aware). The advertising of the chair, the money provided by the bank to finance all the operations listed above, along many other components are all invested so as to create value.

The information age that developed in the last 40 years is a prime example of enormous wealth creation. When compared with the present day, communications devices hardly existed 100 years ago. Those that did were crude by today's standards. Modern devices have created untold trillions in wealth. Mankind has taken grains of sand and created silicon chips, on which inconceivable amounts of information are stored and accessed by millions. Calculations that were unimaginable 20 years ago are done in milliseconds. Exponentially more information is available in seconds on your cell phone than was available 20 years ago in all the libraries in the world combined. Voice communications go around the world, cost pennies, and do it with an ease that nobody thought possible until recently. The benefits of this extend into almost every facet of business and our personal lives. New drugs, new airplane designs, and much more can be modeled on computers which allow development to take place in a fraction of the time, at a fraction of the cost, and far more safely than just a few years ago.

Throughout history society has learned more and more about this process, and the rate of wealth creation has increased far faster than society's ability to consume it. Advances in one field allow for others to piggy back on the new found knowledge and accelerate their own advancement. This has yielded exponential growth, and it continues accelerating today at a record pace. Over 25% of the goods and services that have been created in the history of the world have been created in the last decade. Many scientists claim that scientific information, which oftentimes translates into wealth, is doubling every decade (I'm not sure how one measures scientific information). Think of that. In the next 10 years we will learn twice what was known in all of science from 2000 to 2010, 4 times what was known between 1990 and 2000, and 8 times what was known between 1980 and 1990. All of it serves as a spring board to better longer more bountiful lives, at least in a material sense.

To understand the effects of wealth creation think of Microsoft. Bill Gates and his employees made vast amounts of money for themselves and their shareholders. In addition his products enabled businesses (his customers) to provide new and better products and services thus creating far greater wealth than they ever could have without Microsoft. Everyone profited. Think about Walmart. It is the largest most profitable retailer in the world. A family of four earning $60,000 per year that lives near a Walmart will save about $2,500 per year when compared to a similar family not having one of their stores available. Walmart's efficiencies and expertise create wealth for everyone, shareholders, employees and their customers. Contrary to liberal economic thinking, Henry Ford had it right when he said that a man gets rich thinking how much he can give for a dollar, not how little. That is what Walmart does (much to the chagrin of many liberals). The point is that these companies successes were successes for everyone. The money that shareholders and employees at Microsoft and Walmart made is minuscule when compared to the wealth that other businesses and the public enjoyed because of them. And that is the magic of capitalism.

Keynes and his multiplier effect suggest the economy is some kind of perpetual motion machine. There is plenty of heat and light given off from a bulb so long as the electricity is on. But turn it off, and the heat and light stop. Similarly, when the government spends it increases economic activity, but contrary to Keynes's idea, the moment that spending stops the activity stops. History (and common sense) proves it. He seem to be saying that once the economy is turned on, it will run forever. But we know that without a continuing power supply closed systems fail. Consumption (wealth destruction) is a closed system, a zero sum game. Wealth creation is not. It is the energy that allows consumption to exist. Can consumption exist without wealth? Never. Can wealth be created without it's being consumed? Of course.

I would argue that government spending not only does not stimulate growth, but actually retards it.
The government creates no wealth. It simply redistributes it and a consumes great deal in the process. The money the government spends can only come from two places, taxing or borrowing from the private sector. The same dollar can't be spent twice. Either way Keynes's imagined "multiplier effect" created by that tax dollar is the same. There is however, one notable difference. Although a dollar in the governments hands only gets consumed, in the private sector that dollar will be partly consumed, and partly invested in an attempt to create more wealth. I submit that an invested dollar has a dramatically different and positive effect on the economy than does a consumed dollar, and investment is the only source of the goods and services needed for consumption.

Growth in a society requires security, protection of private property, a court system, roads, etc. Those and certain other government functions are the infrastructure that allows wealth creation to occur, and in a broad sense they can be conceived of as wealth creation. However, as necessary and valuable as they are, they make up only a tiny percentage of overall government expenditures. Welfare, Medicare, Social Security, and the EPA, are all agencies designed to consume. I am not being critical if as a society we choose to spend money on them, although I would point out the government cost of doing them is far greater than if they were done by the private sector. The debate here is not what government should or should not provide, but whether those expenditures or additional government spending has a positive effect on the economy. 



Individual invest savings to create wealth, companies invest retained earnings (corporate savings) or money raised from investors. This pooling of money is absolutely necessary to the wealth creation process. A project may be attractive, but no one individual would expose himself the the magnitude of loss that large projects risk. No large projects would ever happen without a pool of capital that meets its demands. My point is that pooling of wealth and individual investment get stifled whenever money is  drained through taxes and government borrowing.

Of course many attempts at wealth creation fail and end up becoming wealth destruction. Investments often turn sour and become worthless. But history has shown that the value of the successes dwarfs the combined losses from the failures. Suppose there were a million failed attempts at designing a hammer before one succeeded? Wouldn't that single success have created millions even trillions more times the wealth than the total of the failed attempts destroyed? There are few if any changes in science, commercial development or anything that have not been built on the knowledge gained from many previous failures. Still, immeasurably more wealth gets created than all the losses combined.

Since taxes are the main source of revenue for increased government spending, particularly stimulus spending, one must ask what the effect of higher taxes is on corporations and individuals. Lower taxes and lower spending leave more money in the private sector, just as higher taxes and spending leave less money there.  Ironically, if we supply-siders are correct, (more wealth is created with lower taxes,) in the long run that economic growth provides greater revenue for the government (lower tax rates but higher profits to tax.) One third of a sixteen inch pie is larger than one half of an eight inch pie.

Think about this. The wealthy only have three things they can do with their money. They can consume it, invest it, or donate it to charity. I would argue that although charity is wonderful and often helpful, it can be an inefficient use of money, and worse, it can be a destructive force (see Ford Foundation and The Pew Foundation for details.) But that discussion is for another day. For my purposes here, I have limited the discussion to two choices, consuming and investing. The truly wealthy in America could not consume all their wealth if they tried. No matter how ostentatious they may be, they simply have too much money to spend it all. Because of this, they must invest, and that is a blessing to us all.

The liberal argument is that saving is neither consumption nor investment, and that it creates no economic activity. They couldn't be more wrong. Unless savings are in the form of putting one's money under a mattress, ultimately all savings get invested in an attempt to create wealth. Trace the "safest" of savings devices, US government insured savings accounts. If one deposits money in a bank, the bank adds about ten percent of its own cash to the amount deposited, and lends that entire amount out at a higher interest rate than it is paying to the depositor. That is how it makes money. Some borrowers use the money for consumption, but most use it to finance business and investment, aka create wealth. The point is that even money in pass book savings accounts finds its way into investment.

Keynesian's argue that the rich can afford more taxes and must "pay their fair share," as if this is an ethics debate. They say there is too much income disparity, and that the rich should "give back." I would argue that it may be true that the rich can afford increased taxes, but it is the middle and lower classes that can not afford to have the rich taxed more. No one can afford stripping these job and wealth creators of much needed capital, one of the building blocks of wealth creation. Neither can we afford to strip them of incentives. Some people are willing to work for nothing, but I wouldn't want to bet everyone's economic future on it.

This whole notion of fairness is dangerous and destructive. It undermines the very goals we all seek to achieve. What is fair about bringing income levels closer together if doing so demands that everyone, especially the poor and middle class, lower their standard of living? JFK said he was cutting taxes on the rich because, "A rising tide raises all ships." He was right. No one disagrees that helping the poor is a laudable goal. But if they are to be helped, the rich will get richer. There are only two choices. The rich get richer and the poor get richer, or everyone goes down hill together. History teaches us there is no third way, and there never was one.

In the US every time taxes were reduced total tax revenues to the government increased. This happened under Coolidge, Kennedy, Reagan and Bush. Every time taxes on the rich were reduced, the rich paid more total tax dollars, and they paid a higher percentage of the total tax revenue. Which is better; having higher taxes with fewer jobs and less money coming into the government, or increasing jobs and revenue with lower taxes? Which is better; having the government tax and borrow money, distributing a small portion of the receipts while eating up the rest in the bureaucracy, or using that money to let the job creators and producers do what they do best?

I can not find one historical example where government spending helped any economy. It has been tried in the US, Europe and Japan, and and there is no creditable case when an economy grew as a result. After the Japanese market crash in the late '80s (the market lost 75% of its value), the country tried stimulus..and they tried again..and they tried again..and is still being tried today. Yet the economy has not grown, there has been no job creation and no increase in wages. The only discernible change is what always happens when stimulus is tried. They ran up the national debt to 240% of GDP.

Supporters of Keynes's theory generally credit the highest government spending in US history, that which resulted from World War II, with the post war expansion (1945- 1973) and our emergence from the Great Depression. The commonly accepted story of this and the depression are seriously at odds with the facts surrounding them.

The Cliff Notes version of the depression starts with a near depression in 1920. In 1917 President Woodrow Wilson entered WWI (30 days after being re-elected on a promise to keep us out of the war). He immediately passed massive income tax increases. When the 16th amendment was passed in 1913 (authorizing the federal government to collect income tax) politicians said the top tax rate would never go above 7 percent.  By the end of Wilson's term 7 years later it was at 77 percent. These and other redistributive, anti business policies led to a near depression in 1920. When Wilson left office the economy had shrunk by 25 percent, government debt had skyrocketed (in part due to WWI, but not all), and unemployment was at 20 percent.

In 1920 President Harding (and then Vice President Coolidge who assumed the Presidency when Harding died shortly after taking office) lowered government spending by 50 percent over 8 years. Think about that when today's politicians tell us that one percent cuts would be draconian. Coolidge began a series of tax reductions unprecedented in US history. In 1928 when he left office, he had lowered the top rate from 77 to 20 percent, but more impressive is that the top rate was paid by only 2% of Americans. Let me repeat that. Only 2 percent of Americans paid the top 20% rate. When he left office unemployment was the lowest in American history, one half of one percent. It had averaged 3.3 percent during his eight years, dropping from 20 percent when he entered the office. After unwinding much of the pro union legislation, real wages went up at an unprecedented rate across the board. Revenue to the government skyrocketed and the national debt was reduced by one third. Needless to say economic growth was record setting. The nominal growth may not have looked very impressive, but that is because there was so little inflation. Real growth (nominal growth minus inflation) was spectacular.

The real depression story is that the Hoover's and then Roosevelt's attempts to bring us out of what would probably have been no more than a severe economic downturn, actually exacerbated the problems created by the1929 stock market crash and turned a recession into a the great depression. The country mired in it for over a decade. Many people believe the '29 crash occurred because of central banks around the world providing easy money, known in the US as an accommodative fed policy. That along with a market bubble created by the euphoria of the exceptionally strong economy were both to blame. In those days bank policy allowed 10 times leverage on stock purchases. Investors needed $100 to buy $1,000 worth of stock.. People were betting 10 times their entire worth on the market. When stock prices declined, this leverage forced massive selling, which in turn drove the market down farther, causing even more severe price declines. In a free market bubbles occur, and they burst. But if policy makers leave the economy to its own devices, it always heals itself and grow beyond the last high point it achieved. It never fails however that when politicians intervene the healing process is extended well beyond what it otherwise might have been.

After the crash unemployment jumped from near zero to 15%, and the economy began to shrink quickly. It took a little over a year for the first legislation designed to "help" the economy to get passed. During that year, the pre-legislation period, when things were able to heal on their own with no "help" from the government, the economy began to grow and unemployment came down to 9%. When the "help" from the Hoover administration arrived, (for example The Smoot Hawley Act which imposed tariffs on imports sparking a world wide trade war) everything went to pieces with unemployment jumping past 20% and the economy shrinking. The policies of first Hoover and then Roosevelt in 1932 (higher taxes, more spending, protectionism) kept a boot heel on the neck of the economy, preventing any type of resuscitation until after WWII.

Stimulus was tried repeatedly between 1929 and 1940 and it failed miserably. Henry Morgenthau, Roosevelt's Treasury Secretary, famously said, “We have tried spending money. We are spending more than we have ever spent before and it does not work. After eight years of this administration we have just as much unemployment as when we started, and an enormous debt to boot!” Those who believe in Keynes theory also fail to acknowledge large tax and spending cuts along with massive deregulation in 1946 and 1948, which we supply-siders would argue was the real engine of growth. The forces propelling our emergence from the depression were congressional rejection of Truman's spending/ stimulus plan and replacing it with what we now call supply-side incentives; lower taxes, lower regulation and lower government spending.

Keynes supporters and liberal economists often point to Bill Clinton's tax increases in 1993 and the following economic expansion as a successful example of applied liberal economic theory (spell that tax increases and spending increases.) I would argue that the income tax increases probably hurt the economy, but they were dwarfed by other positive factors introduced under Clinton. He signed a capital gains tax cut into law, a far more important tax on investment than the earned income tax that went up. He signed the North American Free Trade Agreement into law, creating a massive increase in trade. Along with congress he cut government spending (not increases as Keynes might have liked) eventually balancing the budget. And lest we forget one of the largest wealth creation events in history, the internet explosion which is the bridge that is taking us from the industrial age to the information age, fundamentally transforming the entire world's economy. The tax increase impact was minuscule compared to these accomplishments.

Another argument liberal economists make is that tax cuts will "blow a hole in the budget." Their claim is that the permanent extension of the Bush tax cuts would cost the government 3.7 trillion dollars over 10 years. This is wrong on so many fronts it's hard to decide where to begin.

First, the CBO (Congressional Budget Office) made this $3.7 trillion determination through legislatively mandated methods of calculation. They are required to use a patently false premise; that people don't change their behavior with changing tax rates. It assumes we will all make the same investments, take profits and losses at the same time, and act in the same manner no matter whether rates are 20% or 70%. An example of this delusional thinking is the luxury boat tax in 1990. It imposed a 10% tax on all boats costing over $100,000. The CBO projected a huge tax revenue increase based on 10% of the prior years boat sales. They were 180 degrees off the mark. People simply stopped buying boats. When the dust settled, the government collected tens of millions less than the CBO estimate, 100 boat manufactures went out of business (about 75% of them), 25,000 boat industry jobs were lost, and an additional 75,000 other jobs were estimated to have been lost as a result of the industry decline. The CBO has become a political tool by which politicians can make ridiculous statements and then use something "official" and nonpartisan to support them.

The language used in the debate favors the Keynesians because we supply-siders often fail to point out the false assumptions embedded in many of the oppositions assertions. Words like stakeholders imply that the consumer is somehow a part of the production process, and has rights because of it. They have the right to expect truthfulness about the product, product safety, and that environmental and other laws be complied with. But they are not entitled to make business decisions for the company or co-opt the wealth the company creates. All manner of wealth transfers occur under the compassionate sounding euphemism of "social justice," moving money from producers to consumers. Real social justice, something that really benefits the everyone, is real respect for private property, the oxygen that allows capitalism to provide the most bountiful material harvests known to mankind.

It has been demonstrated 1000 times over that if you want less of something, tax it. More taxes mean less wealth for everyone, including those receiving benefits. When the Democrats say that Republicans want tax cuts for the rich, and rich corporations that would "punch a hole in the budget," the Republicans should answer yes they certainly do want the cuts. They want them because the economy will expand, increasing tax revenue. They want lower taxes because they want more jobs and higher wages, and lower taxes (especially for the rich) mean people will invest money doing exactly that. Government money simply determines which non producers should consume the fruits borne of some real producers efforts.  Not surprisingly, the recipients of this largess are usually groups that benefit political decision makers.

The Keynesians and their followers (main stream media for one) love to assert that "everyone agrees" that cutting spending during a recession is a recipe for disaster. No, everyone does not agree. In fact I would argue that among the people who have no political interests to serve, the overwhelming majority disagree. Margret Thacher cut spending to the bone during one of the worst recessions Great Britain ever endured, and when the dust settled the country enjoyed the greatest economic expansion in their history. There are numerous other examples. History shows that over time, reduced government spending may initially reduce economic activity, but shortly after it has the effect of increasing economic activity, jobs, and wealth.

Up until now I have tried to contain at least some of my considerable bias. But I really think that Keynes theory has as much validity and makes about as much sense as a perpetual motion machine. It reminds me of the joke (this describes the theory exactly) about a businessman who would buy watermelons for three dollars and sell them for two, but figured he could make up for the loss with increased volume. I am also reminded of Winston Churchill who said, "We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle." Isn't that exactly what Keynes has proposed? He is saying the more we consume, no matter how wasteful, the more wealth we will have to consume. This is bizarre at best. Yet in the face of repeated and consistent failures, our politicians continue to appropriate money for just such folly.

John F Kennedy was a committed supply-sider. One of his signature achievements has all but been written out of the history books (academics are generally liberal and since the facts here contradict their economic theories/ bias they simply ignore them.) About a month after his death the tax plan he had promoted for months, got enacted. It rapidly produced jobs and wealth just as he predicted. Here are a couple of his numerous quotes on the subject. 

"In short, it is a paradoxical truth that ... the soundest way to raise the revenues in the long run is to cut the (tax) rates now. The experience of a number of European countries and Japan have borne this out. This country's own experience with tax reduction in 1954 has borne this out. And the reason is that only full employment can balance the budget, and tax reduction can pave the way to that employment. The purpose of cutting taxes now is not to incur a budget deficit, but to achieve the more prosperous, expanding economy which can bring a budget surplus."
– John F. Kennedy, Nov. 20, 1962, news conference

"The largest single barrier to full employment of our manpower and resources and to a higher rate of economic growth is the unrealistically heavy drag of federal income taxes on private purchasing power, initiative and incentive."
– John F. Kennedy, Jan. 24, 1963, special message to Congress on tax reduction and reform

Of course Keynes is not alone in developing crackpot economic theories. One seemingly everlasting fiction is that minimum wage increases help people earn more. Not only does it make no sense (if it had merit we should raise everyone's wages to $1,000 per hour, or better yet, $10,000 per hour), but the history of implementing minimum wages has always resulted in the loss of jobs, productivity, and thus wealth. Another continuously repeated foolishness is the hubris that government can control inflation with wage and price controls. Nixon and Carter were the most recent American presidents to employ this nonsense. It resulted in an entire dislocation of economic forces giving us some of the highest inflation in our history and one of the severest recessions. Our current president is trying the same failed approach in the recently passed health care bill with government imposed prices and regulations, and the financial regulation bill, determining what banks can and can not charge. I can't be sure exactly how this will play out, but it will be ugly. It always is. Who would have thought than the ethanol bill mandating that 10 percent ethanol be mixed with gasoline would inflate world food prices faster than any time since 1976. But it did.

Some results of government tampering are easily predictable. What makes it frightening is that often times failure is obvious to everyone except those making the decisions. For anyone who doesn't realize that taking away someone's incentive to work will result in their not working, we now have almost 50 years of history proving it. In this land of plenty there are 5th generation welfare recipients. If your mother and grandmother were on welfare, if that was the universe you were exposed to, what chance would you have of finding gainful employment? Welfare does not serve the poor. It is a maximum security economic and spiritual prison from which few ever escape.

Congress gave money to homeowners who are underwater with their mortgage in an attempt to bail them out. The result after spending billions; most re-defaulted. The worse part is that until a bottom to the housing market is reached, no new construction/ job creation/ wealth creation in that industry can begin. In their infinite wisdom congress has delayed that market from reaching bottom, and thus delayed the recovery. It was clear to anyone paying attention that this would happen, but congress proceeded anyway.

Politicians were positively giddy at the "success" of the "Cash For Clunkers" program. They congratulated one another claiming the success was beyond their wildest dreams. What happened? The government said that if you owned an old junk car, and if you traded it in on a new car, they would buy it from you at somewhere between two and twenty times its market value. No surprise, people took them up on it. Inducing people into selling their car for much more than it is worth seems like a no brainer to me, but in Washington it is called an astonishing success. Oh, for the record, car sales slumped as soon as the program ended. Congress succeeded in two things. They moved car sales forward in time without increasing total sales at all, and they gave away billions of taxpayer money.

At the beginning of this I said you would decide. It is now time. If I have been convincing, don't allow someone's scholarly credentials or someone's false assertions to sway you. For decades academia has been singing the praises of their false god, Keynes. Everyone has an agenda, everyone has a bias, myself included. Therefore, your best defense against being misled is to apply your life's experiences and a good dose of common sense to the facts, and then decide. Ronald Reagan said most of the answers are simple, they're just not easy. Knowing what will work is clear, but having the courage and political will to actually do it is something very different.




1 comment:

Bradley Hennenfent, M.D. said...

Great essay. I enjoyed it and will share your link on social media sites. - BradMD